1-2.8: Prudential banking regulation: selective activism or neutrality?

Prudential regulation applied to banks is caught swinging back and forth between two objectives: on one side, to correct market failures and neutralize them as far as possible, and on the other, to coerce or at least coax banks into adopting strategies and behaviours geared to gaining firm control over individual risks (credit risk, market risk, liquidity risk, operational risk, etc.) and preventing systemic risk.

The dividing line between these two objectives is often blurry, but the distinction helps separate prudential regulation into the strand tied to neutralizing market shortfalls and the strand tied to regulator-led discretionary interventions that often translate as selective activism since they aim to modulate not just the pace but also the structure of financing.

To internalize negative externalities, to curb or absorb information asymmetries between banks and their counterparties (investors/depositors, shareholders, other banks, etc.), to contain systemic risk: there is no shortage of economic rationales for prudential regulation, and they all intertwine efforts to neutralize market imperfections with the activism inherent to any public policy.

The American economist Richard Musgrave’s approach to public expenditure and budget financing distinguished a further three dimensional branches: effect on resource allocation, impact on business cycle and stabilization, and ramifications for income distribution―redistribution. Stretching the analogy further, these three dimensions – allocation, stabilization, and redistribution – are to be kept top of mind as we assess the prudential regulation system governing banking and finances.

This article sets out concrete examples to show how far prudential banking regulation juxtaposes and sometimes even combines systems tied to neutrality or neutralization with other committedly active and interventionist systems. This is why we begin by examining capital adequacy requirements, which equates to the search for a non-neutral position (I). Moving forward, liquidity ratios express the search for some form of neutrality in the balance sheet position (II). However, prudential regulation cannot stay neutral to economic cycles (III).

I – CAPITAL ADEQUACY REQUIREMENTS, OR THE SEARCH FOR NON-NEUTRALITY

Efforts to defend a global level playing field have formed the backbone of Basel Committee standards and policy recommendations since the late-1980s. Looking back, it is easy to forget that before Basel I, the temptation was strong for many countries to appeal to regulatory arbitrage, aligning to the ‘lowest bidder’, i.e. the least stringent capital adequacy standard, and running the risk of structural fragility in their banking systems.

This level playing field objective reflects a pro-neutrality stance on the prudential regulation of domestic or international competition, which I will come back to in the conclusion. However, on every other front, the regulatory approach to bank solvency pushes selective activism over neutrality. Illustrations follow.

The spotlight here is on risk-weighting exposures (1) or risk-weighting bank assets (2). We also take a hard look at the discretionary powers of the regulator-supervisor through the critical lens of Basel II pillar 2 (3), regulation-induced distribution effects (4), and the targeted, selective control of certain banking operations (5).

1°) Risk-weighting exposures

From the outset, the idea with Basel I was to weight bank assets and exposures (credit granted, shares owned, etc.) according to their prospective credit risk.

The credit risk system introduced with Basel I was simple enough, but quickly proved oversimplistic, with only four risk-weight ‘buckets’ (0%; 20%; 50%; 100%) and a heavy-handed framework for dealing with borrowers: all OECD member states were risk-weighted 0%, whereas all private-sector businesses, from the multinational corporation down to the local SME, were hit with the maximum risk weight (100%).

It was the widening gap between the regulatory capital, as computed by this simple risk-weight system, and the economic capital (which would have been better justified given the bank’s real risk profile) that sparked the end of Basel I and triggered the major changes ushered in through Basel II. Even though market risk was finally integrated from 1995 onwards, it was too late an afterthought to save the Basel I system.

Basel II brought an expanded risk-weights scale and with it, more importantly, banks were given a choice between several methods for determining risk weights. Generally speaking, and without going into the finer technical points, banks had the option of choosing between the regulator-set ‘standardized’ model or else their own internal-ratings systems involving varying layers of sophistication depending on how far each bank integrates its own specific risk parameters. This decentralized choice offered out to each financial institution extended to credit risk, market risk, and operational risk ― a risk category covered under Basel II and Basel III but ignored by Basel I.

The standardized model is also known to give centrestage to any credit ratings available from credit ratings agencies and credit insurance institutions. Only 15% of the overall number of businesses in Europe are credit-rated by external agencies, but the percent coverage is far higher if the accent is given to turnover or market capitalization instead.

Today’s credit rating agency failures have come back to haunt yesterday’s decision to give ratings agencies such an officialized prudential regulatory role, and although moves to downplay the agency ratings are now underway, there is no telling where they are going to be effective.

To prevent competitive distortion and aim for a true level playing field, national regulators ‘assess’ the quality of the banks’ internal ratings systems for the full panel of risk components. This arrangement cuts down the options for strategic manoeuvring by certain banks and minimizes the risk of undervaluation as regards equity and quasi-equity requirements.

The need to mobilize a referee reflects how the banks are caught up in a competitive neutrality issue, but does not compromise the essence of the system, which is the need to mobilize selective activism. The risk-weightings scale effectively prompts the banks to opt for low-weight commitments to save equity (in particular tier 1 and core tier 1) and quasi equity. This partly narrows the gap between regulatory capital and economic capital, since the major international banks opting to appeal to their own sophisticated internal ratings models integrate their own parameters to compute their capital adequacy requirement.

The risk-weightings scale is therefore anything but neutral. This extends not just to credit risk and market risk but equally to operational risk. It therefore follows that any bank employing the standardized approach to calculate the operational risks will, all other things being equal, have to hold more capital if it finances business rather than the retail market and if it deals in payments and settlements rather than asset management.

The leverage ratio ― already nexus of North-American prudential regulation and fast-tracked into Basel III under US pressure ― does not weight bank commitments in terms of their riskiness. This is what makes it so simple (to compute) yet also oversimplistic. It is not, therefore, the reciprocal, in the mathematical sense of the term, of the global solvency ratio that effectively does weight the risks.

Assessed in from this perspective, the leverage ratio would appear more neutral to bank liability structure. Even though the two concepts are not wholly redundant, there are grounds for asking why Basel III is ready to combine the two approaches, as once juxtaposed, they could ultimately ‘overdetermine’ the system. My feeling is that experience will probably tell us to downscale the role given to the leverage ratio, even it means finding other ways to account for some of the information leverage ratio offers on a bank’s overall riskiness.

2°) Risk-weighting bank assets

The upward-revision of capital adequacy ratios from Basel II to Basel III concerns various categories of capital. Between now and 2019, minimum floors will switch from 2% to 7% for core tier one (CTO), 4% to 8.5% for tier one, and 8% to 10.5% for the overall capital adequacy ratio.

We know that the crisis has jolted Europe into a unilateral decision to previse tougher and earlier new prudential regulation standards, since the major financial institutions will need to have a CTO of at least 9% as of 2013.

The figures above show that the banks are being asked to make the most effort on the CTO ratio, which is more than tripled whereas tier one is roughly doubled. This is glaring evidence of a defiantly non-neutral approach to the quality of the whole capital structure (including quasi-equity) of the banks.

This prudential regulation approach ties up with the approach adopted by the markets as well as the rating agencies and financial analysts who, for years now, have been over-weighting ‘hard’ capital equity, especially since the late-2000s crisis. As things stand today, under the Basel II framework, or what is now dubbed “Basel 2.5”, the major international banks are posting capital adequacy ratios of 9 to 10%, i.e. just over the minimum requirement so as not to choke their return on equity (ROE). Yet this all-round level is often reached with a CTO of 7 to 8%, which leaves little room for ‘softer’ capital equity and quasi-equity.

3°) Discretionary powers of the regulator-supervisor: Basel II, Pillar 2

The banking regulator–supervisory reviewer in each country can set prudential requirements that go further than the minimum regulatory standards depending on how they assess a bank’s risk profile. This case-by-case process is built on the grounds that a bank’s risk profile cannot be fully captured by the system of risk-weighting its exposures (were this not the case, then there would be no much need for this added requirement).

Pillar 2 of Basel II covers a broader scope than just the regulator’s discretionary power, since it is connected to improving banking supervision in general. However, the core premise of Pillar 2 is materialized through this layer of judgement and decisionmaking authority left to the regulator, which was already a practical reality in Basel I and is set to be anchored long-term under Basel III.

The regulator’s discretionary power is vital, as it aims to strengthen the resilience of certain financial institutions to the risks they take and thus contain systemic risks they may have to face. It also inevitably interferes with market mechanisms, which of course is exactly what it sets out to achieve. Asking a bank to hold a capital adequacy ratio of 12% instead of the 8% minimum requirement under Basel II means stressing its net financial profitability (ROE), but this intervention is for a good cause, i.e. the health of the banking system.

Should the regular–supervisor deploying Pillar 2 be fully market-transparent, openly and publicly reporting when and why each individual decision was adopted? The debate continues, although a shift towards more transparent financial information looks to be gaining ground.

Looking in from outside, you would say it is down to the credit firms to communicate around them (to their shareholders, their customers, etc.) on the added constraints they may have to contend with.

Naming “systemically important” banks translates the same approach as Pillar 2, just by a different procedure. It is the Financial Stability Board (FSB) that lists the global “systemically important” banks compelled to comply with tougher capital requirements laws. Published in November 2011, the FSB list counts 29 global systemically important banks considered too big to fail, and which will thus have to face a capital surcharge of between 1% and 2.5%.

The exact figure for this surcharge will be set in 2014 on a case-by-case basis, by aggregating a set of criteria that translate the probability a target bank’s failure could snowball into systemic risk. This system will come into full force in 2019. The FSB will regularly update its list in response to changing bank structures and shifts in scope of the “too big to fail” principle.

4°) Prudential regulation-induced distribution effects

Any and all prudential regulation and any and all changes in prudential regulation will necessarily lead to distribution effects, and thus winners and losers, either in terms of absolute figures or relative value.

Let us look at two concrete examples. Firstly, the upward-revision of capital requirements ushered in with the switch from Basel II to Basel III does not really handicap well-capitalized banks, but it does weaken the position of credit institutions caught flirting with the minimum regulatory requirements. The upshot is that we will predictably see a surge in M&A operations, as fragile banks make prime targets for stronger banks.

Secondly, risk-weighting bank exposures via the standardized model or internal ratings models pushes banks to finance big corporations rather than small and medium enterprises. This tactical bias is there before regulation steps in, but regulation only makes it stronger. This is already the case with Basel II, and could get worse when Basel III raises its capital adequacy ratios.

5°) Targeted, selective control of certain banking operations.

The ongoing global financial crisis triggered in 2007 has prompted much tighter scrutiny on securitization and OTC derivatives markets.

It sparked a brutal freeze ― and rightfully so ― on the securitization process, which was patently accountable for much of the opaqueness of the financial system and its relatively untraceable risk-taking. The banks have been then only gradually allowed to start resecuritizing part of their credit debt again, and only under tight regulatory control.

Today, a consensus has emerged on two core measures: 1) oblige banks to keep hold of a significant fraction of their own issued credit; 2) if securitization is not taken off-balance sheet, bring in a purpose-built package of special prudential measures.

The crisis also threw the spotlight on systemic risks liable to find their way onto OTC derivatives markets. Credit default swaps (CDS) are high on this agenda since the debate opened at the April 2009 London G20 summit.

Step back and look at the orders of magnitude involved, working out from the notional values, which sum up the scale of the contracts but give no information concerning the risks exposure (and which, fortunately, come to only a fraction of the value of the contracts).

Figures for June 2011 put the estimated total notional amount on financial instruments worldwide at around $790,000 billions, including $708,000 billions (almost 90%) on OTC markets ― of which only $32,400 billions in CDS. Clearly, the G20’s FSB framework lends inordinately large attention to CDS given their relatively modest share in the total of derivate instrument contracts, but the approach reflects the opaqueness of the CDS market (whether corporate or sovereign) and the concentration of CDS transactions bunched on a handful of big players. A concentration which is liable to increase systemic risks.

The G20 sent out a clear statement from the London Summit on the target set: to migrate CDS over to clearing houses in order to get a better grip on the level, distribution and traceability of the risks involved. This target goal needs to be incentivized rather than coerced. In practical terms, this will entail making sure that under Basel III, a CDS between, say, a bank (buying protection) and a hedge fund (selling protection) will be less equity-intensive for the bank if the transaction goes through a clearing house than on the genuine OTC market.

Prudential banking regulation cannot afford to overlook the role of incentives, which can prove more effective than many of the toughest regulatory constraints as they are less likely to motivate financial innovations to circumvent regulatory requirements.

II – Liquidity ratios, or aiming for neutrality in the balance sheet position.

Before we move ahead to tackle liquidity ratios in search of finding neutrality in the balance sheet position, we need to go right back to the question of where a bank finds its roots ― a question thought to involve maturity transformation (1). The financial crisis has challenged and shaken the conventional scheme, but the bank-as-maturity-transformer model finds its limits in Basel III (2).

1°) Maturity transformation: the roots of banking?

A host of banking economics textbooks will tell you that the primary role of a bank is to transform short-term liabilities into mid/long-term assets. The bank holds its assets for a far longer term than its liabilities, so as to capture the net interest margin when the yield curve is upward sloping. However, this also exposes the bank to interest rate risks (if the yield curve inverts) and illiquidity, in case of a run or if the bank struggles to refinance on the interbank money market.

It is this transformation function that enables banks to fund long-term projects ― or at least be in a position to do so ― and that, on top of the information asymmetry between banks and depositors, justifies the deposit insurance scheme.

Then came the financial crisis that broke out in 2007, severely testing confidence between banks, as no-one was sure of the real level of risk the others were facing, and sparking a banking liquidity crisis. It also sparked consciousness of the need to learn some hard regulatory lessons. Before 2007, the prudential regulation of banking liquidity was deficient, very heterogeneous, and riddled with holes.

For example, a third of EU member states had no regulatory scheme to keep banking liquidity in check, while in the remaining two-thirds that did, prudential regulation was ― and continues to be ― wildly different across countries. This could come as an eye-opener, given the level of commitment the EU was ready to channel into far less important issues than banking liquidity.

2°) Limits to the maturity-transformer model in Basel III

To make doubly sure of its effectiveness, Basel III combines two liquidity ratios. The first is a short-term ratio called liquidity coverage ratio (LCR), which pits highly-liquid 30-day assets against equally liquid 30-day liabilities. The ratio calculated must be greater than or equal to a regulator-set reference floor. This floor is equal to 100%. It means that the banks have the necessary assets on hand to ride out a bank run or a refinancing bottleneck on the interbank market.

The second is a long-term liquidity ratio called net stable funding ratio (NSFR), which compares long term assets against long term liabilities. The definition of this ratio is not fully fixed yet.

The short-term liquidity ratio will become binding in 2015, whereas the longer-term liquidity ratio is pencilled in for 2018. Experimenting with the two combined ― LCR plus NSFR ―, what surfaces is that to pull their conversion factors down to well under today’s levels, banks are going to have to extend their average portfolio duration and/or shorten their average liabilities duration.

The road to consolidated banking assets promises to be long and uneasy, as there are no signs to suggest savers are ready to change their deep-rooted liquidity preference.

The other path ― shorter asset maturities ― emerges as the most likely way forward, although it leads into some formidable challenges: who, in tomorrow’s world, is going to finance infrastructure projects, sustainable development, small business growth, or even productive investment itself?

The European Commission is well aware of these upcoming challenges, and was wise enough to use the EU-wide transposition of Basel III (deployed via Capital Requirements Directive IV – CRD4) to lay down the core principles for regulating bank liquidity without going into detail concerning the ratios involved. This conscious effort not to get pinned down too early buys some negotiation room for bringing regulators and the bank business to the negotiating table and for improving liquidity arrangements.

III – No escaping the fact prudential regulation cannot stay neutral to business cycles

The first step forward is to posit a differentiated regulation model aligned to whether the target economy has a predominantly bank-based or market-based financial system (1). Moving ahead, we then factor in the effect of the wide spectrum of channels of transmission through which prudential regulation is distilled (2). This broad diversity is part and parcel of why it is difficult to anticipate the economic impact of Basel III (3). What is clear, though, is that prudential regulation is aiming for countercyclical mechanisms (4). Further down the road, we will need to head into a prudential regulatory dialectic (5).

1°) A hypothesis

Debate continues to rage over many dimensions of the economic impacts of Basel III, yet there is one aspect on which there is a broad consensus.

Given that Basel III is directly focused on banks and only partially and indirectly addresses financial markets, the new regulatory standard can be expected to have a greater impact on bank-based financial systems, especially in mainland Europe, than on market-based systems (including the USA and the UK).

With national idiosyncracies pulling finance structures in different directions, any attempt to set a level playing field is skewed from the outset. Generally speaking, mainland Europe raises funds by playing off two-thirds bank borrowing against one-third on capital markets, whereas the USA goes one-third banks and two-thirds capital markets. These proportions may fluctuate in the short term, but basically, they can only see substantial change in the long term.

This argument is not a criticism of Basel II or Basel III, but a call for a wider, more macro-prudential approach to financial re-regulation encompassing the full spectrum of financing strategies, both intermediated and disintermediated.

2°) Regulation and the channels of transmission

Regulation is made effective through a number of channels ― some direct, some indirect ― but there are three that form the backbone:

the interest rate channel. Raising capital requirements could prompt banks to increase their loan rates and/or decrease their deposit rates. This effect has nothing mechanical, as it will be dependent on competition between banks and their ability to offload the rise in equity costs onto their clients (a rise taking place all other things being held constant).
the credit rationing channel. As we know, under certain circumstances, banks will ration the supply of credit to their riskiest clients rather than increase interest rates, based on the rationale that an interest rate hike, once it reaches a certain threshold, creates adverse selection, pushing away less-risky borrowers and pulling in very-risky borrowers who have nothing to lose (J. Stiglitz & A. Weiss, 1981).
the balance sheet channel. We saw earlier that coupling the two liquidity ratios will cut the banks’ mismatching ratios, which can only further escalate credit rationing on a subset of long-term assets.

3°) The expected economic impact of Basel III

The stakeholders in Basel III have been busy running their own simulation model, with, predictably enough, widely contrasting results. At one end of the spectrum, the Institute of International Finance (IIF) is defending its stance that Basel III will have a significant negative impact on growth, through the interest rates channel, the credit rationing channel, and so on. Conversely the FSB points to only a modest and transient effect on growth.

Academics come up with almost the same broad spread of expected outcomes, as reflected in the December 2011 special issue of the International Journal of Central Banking. Among the papers featured, M. Darracq Pariès, Ch. Kok Sorensen and D. Rodriguez-Palenzuela (2011) reached the conclusion that the Basel III reform package can be expected to impact negatively on output via the above-mentioned channels, but that the effect could be attenuated if Basel III is phased in gradually.

This conclusion sits in sharp contrast to A. Admati, P. DeMarzo, M. Hellwig and P. Pfleiderer (2010), who argue that enforcing higher capital adequacy ratios to throttle leverage does not force banks into tightening the reins on credit. Over and above these highly contrasted forward projections, the one clear theme to emerge is that virtually nobody believes Basel III will be economy-neutral.

4°) Aiming for countercyclical mechanisms

Procyclical regulation accentuates the business cycle (visible, for example, in GDP growth rate), whereas countercyclical regulation attenuates it. The financial crisis has thrown the spotlight on the manifold and mutually reinforcing cascade of procyclical factors: not just Basel III but also accounting standards built around concepts like fair value, the policy of credit rating agencies, and so on.

Basel I was moderately procyclical, since risk-weights on bank exposures were kept the same for both peaks and troughs over the business cycle. Under Basel II, the risk weights became endogenous, increasing with the slow-down or even recession (when global default risk also increased) and decreasing with the expansion phase (when global default risk decreases). Indexing asset risk-weightings to the business cycle was a step in the right direction, but it entails spillover effects that need to be kept in check.

The procyclicality bias is kept with the transition from Basel II to Basel III, where it plays a role in all the scenarios, whether banks opt for standardized models or for internal ratings-based approaches.

A move towards more countercyclicality would entail imposing higher capital adequacy ratios during the expansion phase, which would have a self-stabilizing effect on bank lending, and accepting lower ratios during sluggish periods. This is precisely the purpose of Basel III’s new countercyclical buffer. This discretionary buffer, added as an additional safety net on top of the baseline ratios, leaves national regulators free to set an additional requirement from 0 up to 2.5% of capital, to reach the top line in good times and drop to 0% during bad times and periods of stress.

This mechanism should offset some of the remaining procyclicality that is embedded into Basel III. My opinion is that, given the stakes involved, Basel III should have made the countercyclical buffer compulsory across the board.

In real-world practice, how can you identify expansion phases and contraction phases in the business cycle? The idea here is to pinpoint the relevant variables. In a thorough investigation across 36 countries stretching back to 1960, M. Drehmann, Cl. Borio and K. Tsatsaronis (2011) tested the performance of several candidate indicators for separating periods where capital equity needs to be built up (peak phase) from periods where it needs to be released (trough phase) in order to implement a countercyclical action. The authors show that the gap between the credit-to-GDP ratio and its long-term trend is the best-performing indicator. However, more empirical studies are required to confirm or not this study’s findings, so in the meantime, debate is still open.

Another way to offset the procyclicality of prudential banking regulation is to switch to dynamic (or ex ante) provisioning. The 2009 London G20 Summit laid down the principle of moving banks over to dynamic provisioning, where provision are built up before (rather than during) bank crises as a preventive measure. However, since 2009, talks have evaporated… Several countries (Spain leading the way) had implemented dynamic provisioning well before the financial crisis broke out, and the initiative has generally been a success.

Dynamic provisioning does come with its fair share of challenges: it challenges certain core accounting principles; it implies at least partly outguessing a pending crisis, which is always a gamble, even if ex post, it is common to top up or, conversely, dip into the accumulated provisions; it requires a high degree of convergence between the prudential and fiscal handling of the provisions, as banks will not build up dynamic provisions if they are counted as corporate-taxable income.

It is vital that both the G20 and the FSB reopen talks on the issue, since tackling the procyclicality of regulation is such a challenge that it warrants a coordinated all-front approach combining countercyclical buffer, dynamic provisioning, and a handful of complementary measures.

5°) The inevitable regulatory dialectic

The regulatory dialectic put forward by the American economist Ed Kane expresses the fact that regulation and financial innovation rebound off each other, mutually locked into a cat-and-mouse game. A large share of financial innovations are designed to circumvent currently enforced or in-the-pipeline prudential rules.

For example, before 2007, bank-led loan securitization was also a way for banks to slacken off certain prudential restrictions. However, the dialectic does not stop there, and regulators, too, are constantly looking to adapt and adjust in response to the latest financial innovations.

Here again, Basel III will have non-neutral effects, since it will probably drive a new wave of bank-designed financial innovation. It is still too early to give a clear picture of the content or even a name to these innovations. Regulation often finds itself outpaced by market-driven trends, particularly trends in financial innovation.

In the case of Basel III, regulators would be well advised to try and get a step ahead of the game, by outguessing regulatory arbitrage tactics and outflanking new financial instruments. Moves like this cannot stop the regulatory dialectic from playing out, but can help contain some of its effects that place limits on the efficiency of prudential regulation.

Let me close with a word on the global level playing field and the theory of the geographical (non)neutrality of prudential regulation. US regulators are currently implementing Basel II across their 20 to 25 major international banks, which together account for around 70% of the US banking system market share. How will they go about implementing Basel III? It is reasonable to believe the scope will, at best, be the same as for Basel II, and maybe even more restrictive.

The G20, like the FSB, only issues guidelines, and experience shows that market pressure is not always enough to compel banks to align to the toughest standard. Let us just say that prudential banking regulation is set to remain one of the key pieces in the non-cooperative game between Europe, the USA and Japan, as well as emerging economies and developing countries struggling to emerge.

_____

References

Admati, P. DeMarzo, M. Hellwig and P. Pfleiderer, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive”, Working Paper, Stanford University, The Rock Center for Corporate Governance, September 2010

M. Darracq Pariès, Ch. Kok Sorensen and D. Rodriguez-Palenzuela, “Macroeconomic Propagation under Different Regulatory Regimes: Evidence from an Estimated DSGE model for the Euro Area”, International Journal of Central Banking, December 2011

M. Drehmann, Cl. Borio and K. Tsatsaronis, “Anchoring Countercyclical Capital Buffers: The Role of Credit Aggregates”, International Journal of Central Banking, December 2011

Institute of International Finance (IIF), “A Review of the 2012 Basel Work Program”, January 2012

J.Stiglitz and A. Weiss, “Credit Rationing in Markets with Imperfect Information”, American Economic Review, June 1981.

Get our newsletters

1-2.8: Prudential banking regulation: selective activism or neutrality?

your comment